Jocelyn Near

The U.S. Securities and Exchange Commission (SEC) announced on August 15 that it had settled charges against TZP Management Associates LLC, a registered investment adviser, for breaches of fiduciary duty regarding its management fee calculation practices for nine private fund clients related to compensation TZP received from portfolio companies.[1]

There are three notable aspects of this enforcement action:

• First, this is the first time since Gary Gensler stepped down as chair that the SEC has charged a private fund adviser solely with a violation of Section 206(2) of the Investment Advisers Act of 1940 (Advisers Act). Such a violation can be supported by negligence, a lower level of proof than the scienter required to establish a violation of Section 206(1) of the Advisers Act.
• Second, consistent with the SEC’s past practice but not necessarily with the law, the order bases its breach of fiduciary duty charges on undisclosed conflicts of interest without a finding of materiality.
• Third, the Section 206(2) violation pertains to the duty that TZP owed to the private funds themselves. The SEC’s order, however, does not cite a violation of Rule 206(4)-8 under the Advisers Act, which prohibits fund advisers from making false or misleading statements to, or otherwise defrauding, the underlying investors in their advised funds, despite appearing to base the breach of fiduciary duty findings at least in part on the inadequacy of TZP’s disclosures to fund investors.

According to the order, TZP provides investment advisory services to private funds under the terms of each fund’s limited partnership agreement, each of which entitles TZP to receive management fees. Each limited partnership agreement also states that TZP may receive “transaction fees” — defined to include all transaction fees, advisory fees and monitoring fees, or other similar fees — from portfolio companies, but requires that TZP credit back to each fund all of the transaction fees (subject to specified exclusions) to reduce or offset the management fees the fund owes to TZP.

The order alleges that for a period of roughly five years, TZP engaged in two fee offset calculation practices related to its receipt of transaction fees that created conflicts of interest that were not adequately disclosed to the funds or their limited partners and were inconsistent with the relevant limited partnership agreements:

• One, pursuant to management services agreements between TZP and the funds’ portfolio companies, the payment of transaction fees could be deferred either at TZP’s sole discretion or because applicable loan covenants prohibited payment. For five portfolio companies in which all nine of the relevant funds invested, TZP collected interest on such deferred transaction fees but did not include such interest in the corresponding management fee offsets. The order treats such interest as if it were a fee that fell within each limited partnership agreement’s definition of “transaction fees” and resulted in the funds receiving lower fee offsets than they were otherwise entitled to receive.
• Two, for at least one portfolio company in which some of the nine funds invested, TZP calculated the management fee offsets in a manner that, according to the order, amounted to improper double-counting. This calculation practice resulted in lower fee offsets than the private funds were entitled to receive and increased the management fees that TZP retained.

The SEC charged TZP with willfully violating Section 206(2) of the Advisers Act, which prohibits an investment adviser from engaging in any transaction, practice or course of business that operates as a fraud or deceit upon a client or prospective client. As noted in the order, negligence is sufficient to support such a violation. The order does not discuss how TZP’s errors occurred or otherwise elaborate on the basis for its finding that TZP was at least negligent.

Under similar circumstances, the SEC has previously charged private fund managers with violating both Section 206(2) and Rule 206(4)-8.[2] Although the SEC order in this matter highlights its finding that conflicts of interest associated with TZP’s fee calculation practices were not adequately disclosed to the funds’ limited partners, the order does not include a Rule 206(4)-8 charge. That may be because, to fall within the rule’s prohibition concerning disclosures, TZP’s misstated or omitted facts had to be material, and the order contains no such finding. Contrary to the text of the SEC’s own Form ADV [3] and case law as recently as April of this year [4] that requires investment advisers registered with the SEC to disclose only material conflicts of interest, [5] the order does not describe TZP’s undisclosed conflicts of interest as material.

On the other hand, it may be relevant that the order cites the standard of negligence rather than scienter. The text of Rule 206(4)-8 does not mention the mental state required to establish a violation of the rule. Although Rule 206(4)-8’s Adopting Release states that scienter is not required to establish a violation of the rule, current Chairman Paul Atkins, who at the time was a commissioner under Chairman Christopher Cox, expressed and explained in detail a contrary view. [6] In light of that view, as well as the diminished import of certain agency pronouncements after the U.S. Supreme Court’s ruling in Loper Bright Enterprises v. Raimondo last year, [7] it may be worth monitoring the SEC’s ongoing approach regarding the requisite mental state for violation of the rule.

To settle the charges, TZP agreed to pay roughly $502,000 in disgorgement, $6,800 in prejudgment interest, and a civil monetary penalty of $175,000 — totaling more than $680,000. The order does not expressly state whether TZP received credit for cooperation with the underlying investigation or for remediation related to the matter. The total amount due will be deposited into a Fair Fund for eventual distribution to current and former investors affected.

Although SEC Division of Enforcement officials have stated that they plan to prioritize individual accountability,[8] no individuals were charged in this matter, and there is no indication that the investigation is ongoing.